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Tuesday, 16 August 2011

Crony Capitalism at Work

High-speed trading is turning the stock market is turning into a farce, and in the process is turning off an entire generation of investors. It’s speeding up a process — P/E ratio compression — that normally takes a grinding bear market a couple of decades to accomplish. Even after the wake-up call of the May 2010 flash crash, the SEC has done little to foster a healthier market ecosystem.

It looks like computer-driven, high frequency trading shops, which now account for the majority of trading volume, hammers stocks much more quickly than human investors And there aren’t enough human value investors (at these prices) to absorb the supply of high-P/E stocks from high-speed trading shops looking to sell.

These shops aren’t liquidity providers; they’re parasites that worsen volatility, extract economic rents from long-term investors, and make rational investors who aid the vital process of market efficiency want to throw up on their trading screens.

As investment horizons have shortened, the market has gotten dumber — especially regarding the macro picture.

Rather than doubt the sustainability of the economic stats in early 2011, the market didn’t ask any deep questions, and rallied mindlessly. Now that we get a cluster of terrible data points in the space of the past week (downward GDP revisions, ISM near 50, etc.), we take the elevator down in gut-wrenching fashion.

Common sense dictates that GDP and ISM numbers would weaken when new supplies of fiscal and monetary stimulus drugs were cut off, so why was this a surprise?

Both forms of stimulus (fiscal and monetary) remain very aggressive, but it seems the stock market requires off-the-charts stimulus in order to maintain its high valuation. Even after the past weeks’ selloff, the S&P 500 is still trading at a Shiller P/E ratio of 20. I think it’s reasonable for it to trade down into the low-teens, because stimulus has temporarily pumped up corporate profit margins. The catalysts to drive the Shiller P/E into the low-teens should be some combination of stimulus hangover and a rising CPI.

Don’t listen to the strategists spouting “the Fed model” as justifying much higher stock prices. The Fed Model goes like this: “10-year Treasury yields are 2.5%, so the P/E on ‘forward operating earnings’ should be 30,” or 35, or whatever number suits the strategist’s objective.

I heard a strategist selling this garbage on Bloomberg Radio this morning. First of all, the Treasury yield is a completely manipulated instrument, and doesn’t correspond to the cost of capital for corporations through economic cycles. Secondly, the duration of stocks, however you measure them, is at least three to fours times greater than the duration of the 10-year Treasury, so it’s comparing apples to oranges. The Fed model spits out dangerous conclusions for investors. Four years ago, John Hussman used robust statistical analysis to deconstruct and invalidate the Fed model.

So the strategic outlook for stocks remains negative. Valuations remain high and headwinds will start blowing harder against corporate profits. As for the tactical environment facing stocks…

Europe is the reason for yesterday’s 5% market crash. Bank runs are rumored to be hollowing out the Italian banking system. This “fear trade” will likely continue until the European Central Bank reverses course from its tightening stance, and aggressively buys PIIGS bonds. Most central banks will yet again inflate their balance sheets, which will only exacerbate the stagflation plaguing the global economy.

We should get a relief rally in the S&P 500, but probably not until we go lower — low enough to panic central bankers. German central bankers in particular will change their “hard money” tune once they see their domestic banking system at risk. I agree with the “hard money” central bankers’ view on subsidizing the PIIGS, but ultimately, a critical mass of European central bankers will push for a policy of ballooning the ECB’s balance sheet.

After the next bout of coordinated global central bank easing, I think we’ll transition into a grinding, sideways-to-down market. Gold prices should benefit from a new round of easing.

This is not 2008. I’m confident at this point that the crisis has transitioned to the following: private capital and small business withering on the vine, as each sovereign debt flare-up elicits a new round of central bank easing. This applies to nearly every economy, including the U.S., the euro zone, China, and Japan.

Crony capitalism is, unfortunately, still a dominant force. It slows the healthy process of creative destruction, slows the mobility of capital and labor, and keeps consumer prices higher than they otherwise would be. But it’s the price we paid for the 2008 bailouts.

Cronyism will eventually come back to bite most big banks and corporations as the inflation created to fund bailouts works its way into cost structures, which in turn shrinks profit margins.